A company can raise money by selling shares or by borrowing. When it borrows against a formal document that acknowledges the debt, the document is called a debenture. The holder of a debenture is not an owner of the company. He is a lender, and the law treats him very differently from a shareholder, especially if his loan is secured on the company’s property.
Examiners ask for the meaning of a debenture, the types of debenture, and how a debenture differs from a share. The detailed rules on fixed and floating charges, and on receivers, belong to the later topic on insolvency, receivership and charges.
This topic covers the company’s power to borrow, the meaning of a debenture, the formalities for issuing one, the difference between a debenture and a share, and the five types of debenture with the ranking between them.
In 30 seconds
Section 191 of Companies and Allied Matters Act (CAMA) lets a company borrow money for its business or objects, mortgage or charge its undertaking, property and uncalled capital, and issue debentures, debenture stock and other securities. A debenture is an instrument issued by a company that acknowledges a specified debt, usually payable at a fixed date with interest, usually (but not always) with a charge as security.
It must be under the company’s common seal and delivered to the holder within 60 days of its creation (section 192(1)). The holder is a creditor, not a member. There are five types: perpetual (s.196), convertible (s.197), secured or unsecured (naked) (s.198) and redeemable (s.199). A secured debenture ranks ahead of a naked one, and a fixed charge ranks ahead of a floating charge (s.204).
The power to borrow
Section 191 of CAMA provides that a company may:
- borrow money for the purpose of its business or objects;
- mortgage or charge its undertaking, property and uncalled capital, or any part of them; and
- issue debentures, debenture stock and other securities, whether outright or as security for any debt, liability or obligation of the company or of any third party.
The common law also recognises a power to borrow. November 2017 began from the statement that a company has an implied power to borrow money by issuing debentures to the public. The power belongs to a trading company. It is exercised within the limits of the objects clause in the memorandum, because borrowing for a purpose outside the objects would be ultra vires.
The limits on borrowing set by the articles, which usually say how much the directors may borrow without the members’ approval, also apply. The memorandum and articles topic explains both.
What a debenture is
Two meanings
A debenture stands both for the indebtedness and for the instrument that creates it. The word can refer to the debt itself or to the document that records it.
The definition
The syllabus gives the definition in Palmer’s Company Law. A debenture is an instrument issued by the company that:
- is normally, but not necessarily, called a debenture on its face;
- provides for the payment of, and acknowledges the indebtedness in, a specified sum;
- states a fixed date for payment, with interest;
- usually, but not necessarily, gives a charge by way of security; and
- is often, though not always, expressed to be one of a series of like debentures.
In May 2015 the examiners put it more shortly: a debenture is a document that acknowledges and contains the terms of corporate indebtedness. It is in many ways like a share, but its holder is not a member of the company. He is its creditor.
In November 2021 they described it as an instrument, usually under seal, issued by a company, containing an acknowledgement of indebtedness of a specified sum, usually given as a charge on the company’s assets.
The formalities
Under section 192(1), a debenture must be under the common seal of the company and delivered to the debenture holder within 60 days of its creation.
A debenture compared with a share
| Debenture | Share | |
|---|---|---|
| Status of the holder | Creditor of the company | Member (owner) of the company |
| What the holder is paid | Interest, which the company must pay whether or not it makes a profit | Dividend, which may be paid only out of profits and only if declared |
| Security | May be secured by a fixed or floating charge on the company’s property | No security. The shareholder has a claim on the company’s assets only after creditors |
| Repayment | Repayable at the date or on the terms of the instrument | Not repayable while the company is a going concern (a buy-back must follow the strict rules) |
| Voting | No vote at general meetings, as he is not a member | Usually votes at general meetings |
| On a winding up | Ranks ahead of members, and a secured holder ranks ahead of unsecured creditors in respect of the charged property | Ranks last, after all creditors |
| Risk | Lower | Higher, especially for ordinary shares |
The syllabus calls shares and debentures the two main means by which a company raises capital. The earlier topic on capital and securities covers shares.
The types of debenture
Debentures may be classified as follows. In May 2018 the question asked for three types, and the examiners’ answer listed perpetual, convertible, secured and naked debentures.
| Type | Section | Features |
|---|---|---|
| Perpetual | 196 | Made irredeemable, or redeemable only on a contingency, however remote, or after a period of time, however long. Redemption means repayment of the loan the debentures secure |
| Convertible | 197 | Issued on terms that, instead of redemption or repayment, the holder or creditor may convert them into shares in the company, on the terms stated in the debenture |
| Secured | 198 | Charged for repayment on particular property of the company. May be secured by a fixed charge on certain property, a floating charge over the whole or a specified part of the undertaking and assets, or both |
| Unsecured (naked) | 198 | No property is charged with repayment. There is only a solemn promise under seal by the company to repay the debt |
| Redeemable | 199 | May be redeemed at the company’s option at any time, as the company decides |
Secured and naked debentures
The syllabus draws the line this way. A secured debenture has a charge in its favour, and the charge may be floating or fixed. A naked debenture has none. Two rules of priority follow:
- a secured debenture takes precedence over a naked debenture; and
- a fixed charge is superior to a floating charge. Section 204 gives a fixed charge priority over a floating charge on the same property, unless the terms of the floating charge forbid a later charge ranking ahead of it and the holder of the later charge knew of that term.
Redeemable and perpetual
These two should not be confused. A redeemable debenture can be repaid when the company chooses. A perpetual debenture is not repayable unless a stated event happens or a stated time passes, however remote. The law allows a debenture to be perpetual and does not treat it as invalid because it is irredeemable.
Working through the rules
Which type is it?
| Facts | Type | Reason |
|---|---|---|
| A bank lends ₦50m on a document under seal that charges the company’s factory | Secured (fixed charge) | Particular property is charged |
| A lender takes a document under seal promising repayment in five years, with no charge | Naked | No property is charged |
| The holder may swap the debenture for 100,000 shares | Convertible | Conversion into shares at the holder’s option |
| The company may repay the debenture whenever it likes | Redeemable | Redemption at the company’s option |
| The debenture is repayable only if the company is wound up | Perpetual | Redemption only on a contingency |
| A bank lends against a charge over all stock-in-trade and a mortgage of the head office | Secured by both floating and fixed charges | Both kinds of charge in one debenture |
Conversion
A convertible debenture of ₦10,000,000 may be converted at ₦100 a share. The holder who exercises the option receives 100,000 shares, and the debt is extinguished. He then becomes a member of the company, with the rights of a shareholder.
The sixty days
A company creates a debenture on 1 March. It must deliver the sealed debenture to the holder within 60 days, that is, by 30 April.
Ranking on a winding up
A company with assets of ₦100m owes ₦60m to a secured debenture holder (charge over the factory worth ₦70m) and ₦30m to a naked debenture holder. The secured holder is paid from the factory first. The naked holder shares with the other unsecured creditors in what remains. The later topics on winding up and charges explain the order of priority among other debts.
Worked problems
Problem 1: raising money for a big contract
Scenario. Chief Afeez, chairman of Afeez Ltd, has won a ₦500 million contract beyond the company’s capacity. He proposes to raise funds by issuing shares to friends and by issuing debentures. Explain briefly (a) company securities, (b) a debenture, and (c) how a debenture holder differs from a shareholder.
- Securities. They are the instruments by which a company raises capital: shares, stocks, bonds, debentures and notes.
- Debenture. An instrument under seal acknowledging a specified debt, usually carrying interest and usually secured by a charge (section 192).
- The difference. A debenture holder is a creditor and a shareholder is a member. The company pays the creditor interest whether or not it has profits, but pays the member a dividend only from profits.
- Power. Section 191 gives the company power to borrow and issue debentures for its business, within its objects.
Problem 2: the unsecured lender
Scenario. Obi lent ₦20m to Zeta Ltd against a document under the company’s seal promising repayment in three years with interest. No property was charged. Zeta is now insolvent. What is Obi’s position?
- The type. The document is a naked (unsecured) debenture, because there is only a promise under seal and no charge on property (section 198).
- The holder. Obi is a creditor, not a member.
- The effect. A secured debenture takes precedence over a naked one, so Obi ranks behind secured debenture holders in respect of the charged property.
- Advice. Obi may claim as an unsecured creditor in the winding up. He is likely to recover only part of his debt.
Problem 3: delivery of the debenture
Scenario. A company created a debenture on 10 January but delivered it to the holder on 20 April. Comment.
- The rule. The debenture must be under the common seal and delivered to the holder within 60 days of its creation (section 192(1)).
- The application. 60 days from 10 January ends on 11 March. Delivery on 20 April was late.
- Advice. The company is in breach of the requirement. It should deliver debentures within the period, and the holder should insist on delivery.
Questions that have been asked on this topic, and how to answer them
| Question theme | What a full answer contains |
|---|---|
| Explain the term debenture (May 2015 Q2(b)) | A document acknowledging the terms of corporate indebtedness, similar to a share but the holder is a creditor not a member. Add the types |
| State three types of debenture (May 2018 Q3(b), 3 marks) | Any three of perpetual, convertible, secured, naked, redeemable |
| Explain four of securities, debentures, share capital, preference shares and shareholder (November 2021 Q2(b), 12 marks) | The definition of a debenture in this topic, and the other terms from the capital topic |
| Fixed and floating charge: differences, description and advantages (November 2014 Q1, November 2017 Q3(c), November 2022 Q4(a)) | Covered in the topic on insolvency, receivership and charges |
| Receivership and the distribution of assets (May 2016 Q6, May 2021 Q2(c), November 2021 Q2(c)) | Covered in the topic on insolvency, receivership and charges |
Common mistakes in the exam
- Calling a debenture holder a member or an owner. He is a creditor.
- Saying interest is paid only from profits. That rule is for dividends.
- Saying a debenture must always be secured. A naked debenture has no charge.
- Confusing redeemable and perpetual debentures.
- Saying a floating charge ranks ahead of a fixed charge. The fixed charge is superior.
- Forgetting the common seal and the 60-day delivery period.
- Describing a convertible debenture as one the company can convert. The option belongs to the holder.
- Using a loan agreement with no formal document and calling it a debenture. A debenture is an instrument under seal.
Quick revision
- Section 191: borrow, mortgage or charge undertaking, property and uncalled capital, issue debentures.
- Debenture: instrument acknowledging a specified debt, usually with interest and a charge. Holder is a creditor. Under seal, delivered within 60 days (s.192).
- Types: perpetual (s.196), convertible (s.197), secured and naked (s.198), redeemable (s.199).
- Secured beats naked. Fixed beats floating (s.204).
- Interest is a debt. Dividend is paid only from profits.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Section A style: multiple choice
Question 1. The holder of a debenture is:
- A member of the company
- A creditor of the company
- A director
- An owner of the company
Show the answer
B. This is the basic difference from a shareholder.
Question 2. A debenture must be delivered to the holder within what period of its creation?
- 14 days
- 30 days
- 60 days
- 90 days
Show the answer
C. Section 192(1).
Question 3. A debenture that the holder may exchange for shares is:
- Perpetual
- Convertible
- Naked
- Redeemable
Show the answer
B. Section 197.
Question 4. A debenture that has no property charged for its repayment is called:
- Secured
- Naked
- Convertible
- Fixed
Show the answer
B. There is only a promise under seal to repay.
Question 5. A debenture that the company may repay whenever it decides is:
- Perpetual
- Redeemable
- Convertible
- Naked
Show the answer
B. Section 199.
Question 6. A debenture that is redeemable only on a remote contingency is:
- Perpetual
- Redeemable
- Naked
- Convertible
Show the answer
A. Section 196.
Question 7. Which of these ranks first in the order of priority?
- A naked debenture
- A floating charge
- A fixed charge
- An ordinary share
Show the answer
C. A fixed charge is superior to a floating charge, and a secured debenture beats a naked one.
Question 8. Section 191 of CAMA allows a company to:
- Borrow, charge its property and issue debentures
- Reduce capital without conditions
- Pay dividends from capital
- Appoint its own auditor
Show the answer
A. For the purposes of its business or objects.
Question 9. Interest on a debenture is payable:
- Only if the company makes a profit
- Whether or not the company makes a profit
- Only to members
- Only at the annual general meeting (AGM)
Show the answer
B. It is a debt. A dividend is paid only from profits.
Question 10. A debenture is usually issued:
- Orally
- Under the common seal of the company
- By the Corporate Affairs Commission (CAC)
- By the auditor
Show the answer
B. Section 192(1).
Section B style: written questions
Question 11 (10 marks). (a) Define a debenture. (3 marks) (b) State the formalities for issuing one. (2 marks) (c) State FIVE types of debenture. (5 marks)
Question 12 (10 marks). (a) Distinguish a debenture from a share. (6 marks) (b) Explain the priority between secured and naked debentures and between fixed and floating charges. (4 marks)
Question 13 (20 marks). Beta Ltd wants to raise ₦200m. It considers issuing shares and debentures. (a) State the company’s power to borrow. (4 marks) (b) Explain secured and naked debentures. (6 marks) (c) Explain convertible debentures and redeemable debentures. (6 marks) (d) Advise on the effect of a debenture created on 1 June that is delivered on 15 September. (4 marks)
Model answers
Show the model answer to Question 11
(a) Definition. A debenture is an instrument issued by a company, normally but not necessarily called a debenture, providing for payment of and acknowledging indebtedness in a specified sum at a fixed date with interest. It usually, but not necessarily, gives a charge as security, and is often one of a series of like debentures. The holder is a creditor, not a member.
(b) Formalities. It must be under the common seal of the company and delivered to the debenture holder within 60 days of its creation (section 192(1)).
(c) Types. Perpetual debentures (section 196), convertible debentures (section 197), secured debentures and unsecured or naked debentures (section 198), and redeemable debentures (section 199).
Show the model answer to Question 12
(a) Debenture and share. A debenture holder is a creditor and a shareholder is a member. The debenture carries interest, which is a debt payable whether or not the company makes a profit, but a dividend may be paid only out of profits. A debenture may be secured by a charge on the company’s property, but a share is not secured.
A debenture is repayable on the terms of the instrument, but shares are not repaid while the company is a going concern. A debenture holder does not vote at general meetings, but a shareholder usually does. On a winding up the debenture holder ranks ahead of the members.
(b) Priority. A secured debenture, which has a fixed or floating charge in its favour, takes precedence over a naked debenture, which has no charge. A fixed charge is superior to a floating charge (section 204), unless the terms of the floating charge forbid a later charge ranking ahead of it and the later chargee knew.
Show the model answer to Question 13
(a) Power to borrow. Section 191 allows a company to borrow money for the purpose of its business or objects, to mortgage or charge its undertaking, property and uncalled capital or any part of them, and to issue debentures, debenture stock and other securities, outright or as security for any debt, liability or obligation of the company or a third party.
The power must be used within the objects clause and any limits in the articles.
(b) Secured and naked. A secured debenture is one charged on particular property of the company for repayment. The security may be a fixed charge on certain property, a floating charge over the whole or a specified part of the undertaking and assets, or both. A naked debenture has no property charged and rests only on the company’s promise under seal. A secured debenture takes precedence over a naked one.
(c) Convertible and redeemable. A convertible debenture is issued on terms that, instead of redemption or repayment, the holder may convert it into shares on the terms stated (section 197). A redeemable debenture may be redeemed at the option of the company at any time (section 199).
(d) The late debenture. A debenture must be under the common seal and delivered to the holder within 60 days of its creation (section 192(1)). Sixty days from 1 June ends on 31 July. Delivery on 15 September was late, so the company is in breach.
Pathfinder on debentures
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Explain the term debenture in relation to a company’s securities. Revise the meaning of a debenture and how it differs from a share.
Revise first: What a debenture is
State three types of debentures. Revise the table of types.
Revise first: The types of debenture
Explain four of company securities, debentures, share capital, preference shares and shareholder. Revise the debenture definition and the share comparison.
Revise first: A debenture compared with a share
Floating charge and its advantages to the company. These are covered in the later topic on insolvency, receivership and charges. Start here with secured debentures and priority.
Revise first: The types of debenture
Source: ICAN Pathfinder, Corporate and Business Law. Diets covered: November Diet, 2014 to May Diet, 2024.
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